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After a contract is concluded between a buyer and a seller, the buyer's bank supplies a letter of credit to the seller.

Seller consigns the goods to a carrier in exchange for a bill of lading.

Seller provides the bill of lading to bank in exchange for payment. Seller's bank then provides the bill to buyer's bank, who provides the bill to buyer.

Buyer provides the bill of lading to carrier and takes delivery of the goods.

A letter of credit is a document from a bank guaranteeing that a seller will receive payment in full as long as certain delivery conditions have been met.

In the event that the buyer is unable to make payment on the purchase, the bank will cover the outstanding amount. They are often used in international transactions to ensure that payment will be received where the buyer and seller may not know each other and are operating in different countries. In this case the seller is exposed to a number of risks such credit risk, and legal risk caused by the distance, differing laws and difficulty in knowing each party personally. A letter of credit provides the seller with a guarantee that they will get paid as long as certain delivery conditions have been met. For this reason the use of letters of credit has become a very important aspect of international trade.

The bank that writes the letter of credit will act on behalf of the buyer and make sure that all delivery conditions have been met before making the payment to the seller. Most letters of credit are governed by rules promulgated by the International Chamber of Commerce known as Uniform Customs and Practice for Documentary Credits. Letters of credit are typically used by importing and exporting companies particularly for large purchases and will often negate the need by the buyer to pay a deposit before delivery is made.

They are also used in land development to ensure that approved public facilities (streets, sidewalks, storm water ponds, etc.) will be built. The parties to a letter of credit are the supplier, usually called the "beneficiary", "the issuing bank", of whom the buyer is a client, and sometimes an advising bank, of whom the beneficiary is a client. Almost all letters of credit are irrevocable, i.e., cannot be amended or canceled without mutual consent of all parties.

A sight LC causes payment to be made immediately to the beneficiary/seller/exporter upon presentation of the correct documents. A time or date LC specifies when payment is to be made at a future date and upon presentation of the required documents.[citation needed]

Negotiation means the giving of value for draft(s) or document(s) by the bank authorized to negotiate, with the nominated bank. Mere examination of the documents and forwarding the same to the LC issuing bank for reimbursement, without giving of value / agreed to give, does not constitute a negotiation.[clarification needed]

Advising Bank — advises the beneficiary at the request of the issuing bank.

Applicant — the party on whose request the issuing bank issues a credit .

Banking day—The day on which a bank is regularly open at the place at which an act to be performed.

Beneficiary — the party who is to receive the benefit (payment) of the LC. The consignee of an LC and the beneficiary may not be the same. The credit is issued in the beneficiary's favor.

Presentation — either delivery of documents against an LC or the document itself.

Complying presentation — when the presentation of documents is in accordance with:

the terms and conditions of the credit

the applicable provisions of UCP

international standard banking practice

Confirmation — a definite undertaking from the confirming bank to honor or negotiate a complying presentation in addition to that of the issuing bank.

Confirming bank — adds confirmation to an LC. It does so at the request of the issuing bank and taking authorization from the issuing bank.

Letter of credit/credit — an irrevocable commitment of the issuing bank to honor a complying presentation.

Honour — to act according to commitment of the LC. Presentations are honored in different ways depending on the type of credit:

Making payment at sight for sight LC.

Incurring a deferred payment undertaking and paying at maturity for deferred payment LC.

Accepting a draft drawn by the beneficiary and paying at maturity for deferred acceptance LC.

Issuing bank — issues the LC.

Nominated Bank — the bank with which credit is available. If no bank is mentioned in the credit as nominated bank, all banks are "nominated".

Negotiation — A nominated bank is said to negotiate a document if it purchases a draft or documents under a complying presentation either by making an advance or agreeing to advance funds to the beneficiary on or before the date on which reimbursement is due to the nominated bank. A draft drawn on a nominated bank cannot be purchased separately.

To receive payment, an exporter or shipper must present the documents required by the LC. Typically, the payee presents a document proving the goods were sent instead of showing the actual goods. The original bill of lading (BOL) is normally the document accepted by banks as proof that goods have been shipped. However, the list and form of documents is open to negotiation and might contain requirements to present documents issued by a neutral third party evidencing the quality of the goods shipped, or their place of origin or place. Typical types of documents in such contracts include:[citation needed]

One of the primary peculiarities of the documentary credit is that the payment obligation is independent from the underlying contract of sale or any other contract in the transaction. Thus the bank’s obligation is defined by the terms of the LC alone, and the sale contract is irrelevant. The defenses available to the buyer arising out of the sale contract do not concern the bank and in no way affect its liability.[1] Article 4(a) of the UCP states this principle clearly. Article 5 of the UCP further states that banks deal with documents only, they are not concerned with the goods (facts). Accordingly, if the documents tendered by the beneficiary, or his or her agent, are in order, then in general the bank is obliged to pay without further qualifications.

The policies behind adopting the abstraction principle are purely commercial and reflect a party’s expectations: first, if the responsibility for the validity of documents was thrown onto banks, they would be burdened with investigating the underlying facts of each transaction, and less inclined to issue documentary credits because of the risk and inconvenience. Second, documents required under the LC could in certain circumstances be different from those required under the sale transaction. This would place banks in a dilemma in deciding which terms to follow if required to look behind the credit agreement. Third, the fact that the basic function of the credit is to provide a seller with the certainty of payment for documentary duties suggests that banks should honor their obligation notwithstanding allegations of buyer misfeasance.[2] Courts have emphasized that buyers always have a remedy for an action upon the contract of sale and that it would be a calamity for the business world if a bank had to investigate every breach of contract.

The “principle of strict compliance” also aims to make the bank’s duty of effecting payment against documents easy, efficient and quick. Hence, if the documents tendered under the credit deviate from the language of the credit the bank is entitled to withhold payment, even if the deviation is purely terminological.[3] The general legal maxim de minimis non curat lex has no place in the field.

Import/export — The same credit can be termed an import or export LC[4] depending on whose perspective is considered. For the importer it is termed an Import LC and for the exporter of goods, an Export LC.

Revocable — The buyer and the bank that established the LC are able to manipulate the LC or make corrections without informing or getting permissions from the seller. According to UCP 600, all LCs are irrevocable, hence this type of LC is obsolete.

Irrevocable — Any changes (amendment) or cancellation of the LC (except it is expired) is done by the applicant through the issuing bank. It must be authenticated and approved by the beneficiary.

Confirmed — An LC is said to be confirmed when a second bank adds its confirmation (or guarantee) to honor a complying presentation at the request or authorization of the issuing bank.

Unconfirmed — This type does not acquire the other bank's confirmation.

Transferrable — The exporter has the right to make the credit available to one or more subsequent beneficiaries. Credits are made transferable when the original beneficiary is a middleman and does not supply the merchandise, but procures goods from suppliers and arranges them to be sent to the buyer and does not want the buyer and supplier know each other.

The middleman is entitled to substitute his own invoice for the supplier's and acquire the difference as profit.

A letter of credit can be transferred to the second beneficiary at the request of the first beneficiary only if it expressly states that the letter of credit is "transferable". A bank is not obligated to transfer a credit.

A transferable letter of credit can be transferred to more than one alternate beneficiary as long as it allows partial shipments.

The terms and conditions of the original credit must be replicated exactly in the transferred credit. However, to keep the workability of the transferable letter of credit, some figures can be reduced or curtailed.

Amount

Unit price of the merchandise (if stated)

Expiry date

Presentation period

Latest shipment date or given period for shipment.

The first beneficiary may demand from the transferring bank to substitute for the applicant. However, if a document other than the invoice must be issued in a way to show the applicant's name, in such a case that requirement must indicate that in the transferred credit it will be free.

Transferred credit cannot be transferred again to a third beneficiary at the request of the second beneficiary.

Untransferable — A credit that the seller cannot assign all or part of to another party. In international commerce, all credits are untransferable.

Deferred / Usance — A credit that is not paid/assigned immediately after presentation, but after an indicated period that is accepted by both buyer and seller. Typically, seller allows buyer to pay the required money after taking the related goods and selling them.

At Sight — A credit that the announcer bank immediately pays after inspecting the carriage documents from the seller.

Red Clause — Before sending the products, seller can take the pre-paid part of the money from the bank. The first part of the credit is to attract the attention of the accepting bank. The first time the credit is established by the assigner bank, is to gain the attention of the offered bank. The terms and conditions were typically written in red ink, thus the name.

Back to Back — A pair of LCs in which one is to the benefit of a seller who is not able to provide the corresponding goods for unspecified reasons. In that event, a second credit is opened for another seller to provide the desired goods. Back-to-back is issued to facilitate intermediary trade. Intermediate companies such as trading houses are sometimes required to open LCs for a supplier and receive Export LCs from buyer.

Issuance charges, covering negotiation, reimbursements and other charges are paid by the applicant or as per the terms and conditions of the LC. If the LC does not specify charges, they are paid by the Applicant. Charge-related terms are indicated in field 71B.[citation needed]

Although documentary credits are enforceable once communicated to the beneficiary, it is difficult to show any consideration given by the beneficiary to the banker prior to the tender of documents. In such transactions the undertaking by the beneficiary to deliver the goods to the applicant is not sufficient consideration for the bank’s promise because the contract of sale is made before the issuance of the credit, thus consideration in these circumstances is past. However, the performance of an existing duty under a contract may be a valid consideration for a new promise made by the bank, provided that there is some practical benefit to the bank[6] A promise to perform owed to a third party may also constitute a valid consideration.[7]

Another theory asserts that it is feasible to typify letter of credit as a collateral contract for a third-party beneficiary because three different entities participate in the transaction: the seller, the buyer, and the banker. Because letters of credit are prompted by the buyer’s necessity and in application of the theory of Jean Domat the cause of a LC is to release the buyer of his obligation to pay directly to the seller. Therefore, a LC theoretically fits as a collateral contract accepted by conduct or in other words, an implied-in-fact contract under the framework for third party beneficiary where the buyer participates as the third party beneficiary with the bank acting as the stipulator and the seller as the promisor. The term "beneficiary" is not used properly in the scheme of an LC because a beneficiary (also, in trust law, cestui que use) in the broadest sense is a natural person or other legal entity who receives money or other benefits from a benefactor. Note that under the scheme of letters of credit, banks are neither benefactors of sellers nor benefactors of buyers and the seller receives no money in gratuity mode. Thus is possible that a “letter of credit” was one of those contracts that needed to be masked to disguise the “consideration or Privity requirement”. As a result this kind of arrangement, would make letter of credit to be enforceable under the action assumpsit because of its promissory connotation.[8]

A few countries, including the United States (Article 5 of the Uniform Commercial Code) have created statutes in relation to letters of credit. These statutes are designed to work with the rules of practice including UCP and ISP98. These rules of practice are incorporated into the transaction by agreement of the parties. The latest version of the UCP is the UCP600 effective July 1, 2007.[9] Since the UCP are not laws, parties have to include them into their arrangements as normal contractual provisions.

Advance payment (most secure for seller) — The buyer parts with money first and waits for the seller to forward the goods.

Documentary Credit (more secure for seller as well as buyer) — Subject to ICC's UCP 600, the bank gives an undertaking (on behalf of buyer and at the request of applicant) to pay the beneficiary the value of the goods shipped if acceptable documents are submitted and if the stipulated terms and conditions are strictly complied with. The buyer can be confident that the goods he is expecting only will be received since it will be evidenced in the form of certain documents called for meeting the specified terms and conditions while the supplier can be confident that if he meets the stipulations his payment for the shipment is guaranteed by bank, who is independent of the parties to the contract.

Documentary collection (more secure for buyer and to a certain extent to seller) — Also called "Cash Against Documents". Subject to ICC's URC 525, sight and usance, for delivery of shipping documents against payment or acceptances of draft, where shipment happens first, then the title documents are sent to the buyer's bank by seller's bank, for delivering documents against collection of payment/acceptance

Direct payment (most secure for buyer) — The supplier ships the goods and waits for the buyer to remit the bill, on open account terms.